The gap between European real estate companies' share prices and private appraisal values is the widest it has ever been following five years of steady divergence. The small asset devaluations that European real estate investment trusts (REITs) reported in the first half of 2020 were insufficient to offset the equity discount to their net asset value (NAV) due to the COVID-19 pandemic putting additional pressure on equity market sentiment. S&P Global Ratings sees the gap between share prices and private appraisal values increasing the risk of falling valuations, aggressive takeovers, and share buybacks, all of which we see as credit-negative for publicly listed REITs.

We view the retail, hotel, and office segments as most vulnerable to the risks of falling valuations and share buybacks. In contrast, we see the residential, logistics, and diversified segments as more exposed to the risk of takeovers, owing to the more positive fundamentals of their underlying assets. REITs in the diversified segment have portfolios with about 25% exposure to retail or hotel assets.

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The Pandemic Has Pushed REITs' Share Discount To NAV To A New High

Equity investors became bearish about REIT stock when interest rates reached a low point

Long-term interest rates are important for REITs owing to their need to refinance frequently, and are a key aspect of their asset value growth. Therefore, we see a high correlation between real estate share prices and central banks' interest rate movements. The decrease in interest rates in Europe since 2011 supported most REITs' traded equity growth up to 2016 (see chart 3). European REITs' market capitalization doubled between 2011 and 2016, while the European Central Bank (ECB) rate fell to 0.10% from 1.5% over the same period.

However, since March 2016, when the ECB lowered its official interest rate to 0%, REITs' share prices stabilized and slowly decreased until the end of 2019, as REITs did not expect as much interest rate optimization as before. Investors' expectations of hikes in interest rates that never materialized, as well as the first signs of weakening in the retail environment, might have also constrained share price growth. The prospect of higher revenue growth--another variable of valuation growth that could compensate for weaker savings on interest costs, in the office sector for example--has not been enough to support equity valuations during this period, in contrast with private appraisals, which have remained buoyant.

In March 2020, equity investors' revenue expectations for European REITs became more negative in light of the pandemic, inducing a sharp decline in their share price, from which the REITs have not yet fully recovered. Today, European REITs' market capitalization is back at its August 2011 level, when interest rates were still at a 10-year high (1.50%).

Chart 3

Private appraisers have remained more bullish in the expectation of growing cash flows from rental properties

Third-party appraisers value REITs' assets every six or 12 months to determine their gross asset value on a fair value basis. These valuations flow into REITs' balance sheets under International Financial Reporting Standards. Similar to equity values, these private valuations grew constantly with the decreases in interest rates over 2011-2016. Low interest rates helped compress the capitalization rate applied to valuations substantially in this period (see chart 4).

However, after the interest rates stabilized in 2016, valuations kept increasing, supported by ongoing direct investments that pushed prices higher. At the same time, valuations have been sustained by higher cash flow expectations (another key variable), thanks to improving economic conditions that typically support REITs' inflation-linked leases and rent renewals.

More recently, the pandemic has pushed appraisers to reduce their assumptions across the board. So far, it seems they have reflected the impact in lower cash flow assumptions, while not yet revising capitalization rates significantly. In the retail property segment--one of the segments most challenged by the pandemic--the drop in values from December 2019 to June 2020 has been on average around 3%. This is a significantly lower decline than those we've seen in the equity markets for retail REITs, such as Unibail-Rodamco-Westfield SE (URW), whose share price dropped by a maximum of 80%.

Chart 4

The gap between REITs' share prices and NAV may narrow in the future

Third-party appraisers started to revisit their asset valuation assumptions in the first half of 2020. After years of valuations increasing, we are now seeing flat or negative valuations in most property segments except residential, and in most of the countries we cover, especially the U.K.

In addition, the equity markets may stabilize at some point, assuming there is more clarity on the full impact of the pandemic on cash revenues for the next few years. In the 2008 financial crisis, European REITs' share prices declined by 75%, before resuming a positive trend in 2011. With equity investors and third-party appraisers progressively aligning their views, especially on cash flow assumptions, we believe the gap between REITs' share prices and NAV may narrow in the future.

No Real Estate Segment Is Immune To Share Price Discounts

The retail segment is facing most challenges in the equity market, but the pandemic is also pushing diversified players into deep water (see chart 5).

Chart 5

Unsurprisingly, as their operating conditions appear more resistant to the pandemic's effects than some other property segments, residential REITs' share prices have also remained more stable, both throughout the pandemic and historically. However, these REITs had a discount between share prices and NAV of about 17% in August 2020. Moreover, residential REITs' share prices fell temporarily in mid-2019, particularly Berlin-focused residential players such ADO Properties S.A. and Deutsche Wohnen SE. This was due to the proposition to implement tighter rent regulation in Berlin, which became effective in February 2020, while asset valuations remain untouched and even positive. The share price discount was therefore higher in the residential than the office segment, but it has now recovered to 2018 levels, before the effect of the Berlin rent regulation.

On the other hand, the retail segment has been at a greater disadvantage in the equity markets. For example, URW's share price fell 62% in the 12 months to June 30, 2020, compared to a drop in the value of its assets under a third-party appraisal of 5.9% in the same period (5.1% in the first half of 2020 and 0.8% in the second half of 2019). The sharp fall in equity values for retail translated into an equity discount to NAV of about 59% as of Aug. 31, 2020, a 145% increase since the end of December 2019.

The trend for working from home and a more uncertain macroeconomic environment are also challenging the share prices of office property owners. Third-party appraisers have not reduced their assumptions significantly in the first half of 2020, with an average like-for-like drop in valuations of 0.1% across our rated portfolio. This translated into a share price discount to NAV of a historically high 36% as of the end of August 2020, diverging significantly from the residential segment. Diversified portfolios have not acted as a hedge against equity turbulence. Equity investors have penalized exposure--despite it being limited--to the more challenged property segments. The average discount to NAV for diversified players reached 48% at the end of August 2020, but this still compares positively with retail.

Interestingly, we have not observed such share price discounts to NAV in the Nordics, and since the middle of 2018, listed REITs in this region have generally traded at a premium to NAV. However, the pandemic has had a significant impact on the equity values of REITs in the Nordics, but the discount to NAV was never more than 25%, and this was for retail. Furthermore, residential and industrial REITs in the Nordics have traded at a premium in the year to date, and their premiums now stand at about 20% and 30%, respectively. A stronger macroeconomic environment and higher growth prospects could partly explain the difference between this region and the rest of Europe.

The Gap Between Share Prices And NAV Could Translate Into Weaker Balance Sheets

Private valuations could follow equity valuations if property investments do not resume

Over the past few years, strong investments in the real estate sector have pushed down capitalization rates, supporting asset values. Direct investments in real estate reached a record high of €248 billion in Europe in 2019. Yet since the start of the pandemic, the volume of direct investments has collapsed. Investments were down 39% in the second quarter compared with the same period last year, especially in the retail and office segments, according to commercial real estate services and investment firm CBRE in its "EMEA Real Estate Market Outlook 2020: Midyear Review".

In the absence of private direct investments, third-party appraisers could turn to transacted volumes in the public equity markets as an alternative benchmark. If appraisers were to reflect more bearish sentiment in their assumptions, mainly through higher capitalization rates, it would likely weaken REITs' balance sheets.

So far, devaluations in the first half of 2020, particularly in office and retail, have been due to a revision of cash flow expectations to reflect a more challenging macroeconomic picture that could translate into lower occupancy levels and rent renegotiations. Capitalization-rate widening has contributed very little to this devaluation, yet we believe that third-party appraisers could still revisit their discount-rate assumptions to reflect higher risk premiums.

We believe the retail, hotel, and office property segments are most exposed to the risk of devaluations, given the lack of benchmark transactions. We expect that valuations in the European retail and office segments should continue to soften by about 10% and up to 5%, respectively, in 2020. This compares with an average drop in reported valuations in the first half of the year of about 3% in the retail segment and flat valuations in the office segment.

Attractive share prices could lead to aggressive takeovers among European REITs

The significant discount of share prices to NAV creates an opportunity for mergers and acquisitions (M&A), because it makes it more profitable to buy a REIT's shares than to buy its assets directly at their latest appraisal value. We believe that the real estate segments with more supportive market fundamentals, and therefore value upside potential, are most exposed to this risk. This could include residential, logistics, or diversified players that have been at a significant disadvantage in the equity markets lately.

We believe that this situation also creates an opportunity for private equity funds to take listed REITs private with sharp share discounts to their NAV. Private equity firms have increased their allocation of funds to real estate substantially over the past few years, and might decide to deploy their dry powder opportunistically. Scale is an important aspect of REITs' cost optimization, and private equity firms might decide to buy large REITs, including distressed retail or hotel REITs, rather than the direct assets. In our experience, private equity ownership would likely entail a more aggressive debt appetite at the target REIT, with lower reporting transparency and governance standards, thus weakening the REIT's overall credit profile.

One REIT's acquisition of another could also put additional pressure on the buyer's credit metrics, as debt funding is often a significant component of M&A in the real estate sector. Moreover, the instability in the equity markets may not guarantee a noteworthy equity contribution as part of the transaction.

Share buybacks are another way to close the gap in the absence of growth opportunities

Record-low share prices represent an opportunity for REITs to buy their own shares to dilute the share price discount to their NAV and boost their share price. For example, Aroundtown S.A. recently approved a share buyback program that would allow it to buy up to €1 billion of its own shares. This strategy is especially relevant in a situation where making new investments might be hard. Most REITs have delayed their expansion plans to conserve capital.

While we understand the rationale, we believe that share buybacks are a use of cash that weakens balance sheets, especially at a time when share prices have been so volatile. Although the strategy is possible across all real estate segments, we believe that the retail, hotel, and office segments may be the most at risk from share buybacks as the share discount to their NAV is material, and they could need to incentivize their existing shareholders by strengthening their share value.

The Debt Market Remains Open, But Persistent Negative Sentiment Could Affect Borrowing Costs

REITs continue to access the debt capital markets

Despite the outbreak of COVID-19 and the sharp widening of yields, the debt capital markets have remained open for investment-grade REITs in the year to date. For example, between April and May, at the peak of the pandemic, URW issued two senior unsecured bonds--a five-year €600 million bond with a 2.125% coupon and a 10-year €800 million bond with a 2.625% coupon--and Klepierre S.A. issued a nine-year €600 million senior unsecured bond with a 2% coupon. In total, absolute rated issuance volumes reached €8.2 billion in the second quarter of 2020, compared to €7.8 billion in the same period last year (see chart 6).

In contrast, the high-yield market has remained shut for REITs, and we have not seen any rated issuance in this market during the second quarter of 2020 compared to significant activity in previous quarters.

Chart 6

Real estate bond yields have widened significantly and not yet recovered

Similar to most other industries, bond spreads in the real estate industry widened sharply across the different property segments after the COVID-19 outbreak. Retail players faced the greatest challenge, with spreads widening by 142 basis points (bps) between Dec. 31, 2019, and April 2020. Diversified players saw also their spreads rising by 143 bps in the same period. Office and logistics players saw less of an impact, and residential REITs saw their spreads recover almost to pre-pandemic levels, with a 20 bps difference between the beginning of the year and the end of August 2020. Although overall, real estate bond spreads widened less during the pandemic than in other challenged industries such as transportation, auto, and media and entertainment, they have not recovered as much as of Sept. 30, 2020 (see chart 7).

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Higher real estate bond yields could lead to an increase in borrowing costs

In general, spreads narrowed after the peak of the pandemic, but were 80% higher on average at the end of August 2020 than at the beginning of the year. Spreads were quite similar for the different property segments at the beginning of the year, whereas now investors have classified the different segments into different risk categories (see chart 9):

• Residential, seen as the lowest-risk investment;
• Office and logistics, seen as posing medium risk; and
• Retail and diversified portfolios with exposure to retail or hotels, seen as posing the highest amount of risk.

While yields seem to have stabilized, a further increase in negative sentiment among debt investors could pose an issue as REITs rely heavily on capital market debt.

Chart 9

Shorter debt maturities have compensated for higher spreads

So far, REITs have managed to maintain their average cost of debt by issuing debt with shorter maturities (see chart 10). However, if spreads don't narrow in the long run, reverting to levels at the beginning of the year, this will likely translate into a higher cost of funding for REITs. At the same time, potential rent relief and declines in occupancy rates due to the pandemic are threatening REITs' EBITDA generation. The combination of these two factors may affect REITs' interest coverage ratios.

Chart 10